Termination of Swap Contract Not a Hedge –
Taxpayer Stuck with Capital Loss Treatment
Taxpayers that use derivative contracts to hedge business risks should consider identifying the derivatives as hedges for federal income tax purposes. The IRS has issued specific rules which must be followed in order to properly designate a contract as a hedge. In a recent ruling, a taxpayer entered into interest rate swaps to reduce its risk of interest rate changes with respect to a debt it owed. The taxpayer did not, however, identify the swaps as a hedge. Later, the taxpayer terminated the swap at a loss, as part of a larger set of transactions including retirement of the original debt, and suffered adverse tax consequences as a result of failing to document the transactions as a hedge against interest rate risk.
In its ruling, the IRS decided that, because the taxpayer had not identified the swap as a hedge, the taxpayer realized a capital loss. Since capital losses can generally only be offset against capital gains, and not against other types of income, the tax benefit from the loss was greatly restricted.
The ruling also addressed when it is appropriate to deduct a loss on a swap contract. In this case, the taxpayer recognized the loss with respect to the swap in the same year it retired the debt, and the IRS held that this timing was appropriate.
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